Drafting international IP licences – watch out for tax risks

We recently posted on certain pitfalls in drafting IP licences.  Well it doesn’t rain, but it pours with these issues, as IBM has recently discovered.  On the receiving end of an adverse Federal Court judgment brought by the Australian Tax Office, IBM has learnt the hard way that the language used to draft an agreement is crucial to how the ATO will treat it for tax purposes. 
The background is that IBM and IBM Australia entered into an agreement which provided IBM Australia with the rights to conduct IBM’s business in Australia.  They regarded it as a distribution agreement and a software licence.  As a result, IBM Australia only paid withholding tax on 50% of the payments attributable to the IP licence as royalties.   The ATO disagreed with IBM Australia’s approach, took IBM to Court and won.
The key clause in the agreement relevantly stated:

“IBM  grants to IBMA under IBM’s Copyrights, Mask Work Rights, and Patents the non-exclusive rights (i) to license and distribute copies of IBM Programs for their ultimate use by customers, (ii) to use such IBM Programs in revenue producing activities, (iii) to use such IBM Programs internally, (iv) to make or have made copies for the purposes described above, for distribution to affiliated companies, and for translation or modification of such IBM Programs, and (v) to allow IBMA’s customers to use, make copies of and modify IBM Programs pursuant to the terms of IBMA’s agreements with its customers.” (emphasis added)

IBM’s overall argument was the grant was of distribution rights and IP rights and that the grant under IP rights of distribution rights was not a grant of IP rights.  The Judge disagreed and construed the grant as a grant of IP rights. Quoting from the case, “Each of those latter rights of use are referable to what may be done by IBMA which may otherwise constitute an infringement of the IP rights. Clause 2 does not grant two separate and severable rights only one of which involves the use of IP rights.”  Interestingly, this is the opposite result to a recent UK case which found that similar language was not a grant of IP rights but a grant of the right to use commodities trading documentation. 

IBM argued that IBM Australia could distribute or use an IBM Program without infringing any IP rights. But the Judge decided that was not the point of the grant clause. That clause purported to grant to IBM Australia whatever IP rights may be necessary. If such a right was not required to enable an activity “so be it”.  IBM also argued that the distribution rights did not involve a use of the copyright rights but the Judge pointed out that the distribution of patented products did involve a use of patent rights. 

This case provides these practical lessons:

  1. Avoid “grant under IP rights” language.  Just grant the distribution and property use rights (if that is what you want)  or expressly grant an IP licence.     
  2. In standard distribution agreements of patented products which cross international borders, you should consider whether it is necessary to include an express grant of the patent rights or just rely on the implied rights which necessarily arise.  If you include an express grant of patent rights, you will need to consider this case.
  3. When you are establishing a distribution relationship then draft it as a distribution agreement with distribution type language.  Then add the IP licence if that is necessary to support that distribution relationship.  In this case, in response to IBM’s submission that the agreement did not “look like a pure copyright licence”, the Judge responded “it is also fair to say that it does not look like a distributor licence”. 

Given the ATO’s  current focus on international transfer pricing arrangements and the Federal Government’s need for revenue, Australian subsidiaries of multinationals should be looking at this case and considering how it applies to their cross border agreements.  In this case, it looks like IBM Australia has underpaid withholding tax for the last 5 years and may end up with a large unplanned tax liability and penalty tax. 

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